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This Bailout Is Terrible!

It could have been the most hated Fool article ever.

My recent article "This Bailout Is Great!" led to polarized reactions. It's among the most recommended article ever on Fool.com, and it probably has the most comments. Typically, comments indicate disagreement. In this case, loathing is probably more accurate.

In light of the reaction, it seemed appropriate to address some of those comments.

No Marxists allowedProbably the biggest misperception about the article was that it was a socialist manifesto by a berserk Obama fan. The problem with this rebuttal is that it doesn't actually address the thrust of the article.

Although I said that capitalism has the occasional blind spot, that's far from a condemnation of free markets. Few would argue that when Freeport-McMoRan(NYSE:FCX) builds a gold mine, it should be allowed to let cyanide leach into the drinking water of nearby towns. There's nothing inherent in capitalism that prevents that sort of behavior. It's a blind spot that we correct through regulation. We have laws because complete free markets neither protect people's rights nor result in a stable society. So, it's unclear why saying that capitalism has blind spots should be controversial.

Concerns Possibly the most common concerns were variants of this comment:

It is absolutely impossible to get a good long-term result from government consumption.

Put aside the fact that the government has been consuming resources for centuries, and that America has been spectacularly successful. The main problem with this argument is that it's entirely ideological. It fails to address the issue at hand and provides no evidence. Though there may be great reasons for believing this point of view, the argument is only convincing to someone who already shares the same beliefs.

Other views were understandable, but missed the point. For instance, one member expressed the frustration many of us feel:

Where is the justice in the pure GREED that was exhibited by the banks and just WHY should future generations be paying for these greedy so called executives??

This view is absolutely right -- there is no justice here. Taxpayers should not be in this position. But the bailout isn't about justice. It's about survival. The central thesis of the article was that without government help, there was a good chance that our banking system would collapse, and that would result in unbelievable pain for all of us.

Prove me wrongRefuting the article requires evidence that the banking system would not have collapsed without the bailout, or that America would be fine with the collapse of its financial system.

Before going down the latter path, consider that on Sept. 18 we had an electronic bank run to the tune of $550 billion in just a couple of hours. According to Congressman Paul Kanjorski, Treasury estimates that had they not temporarily shut down the system and raised deposit guarantees, $5.5 trillion would likely have been withdrawn from the U.S. money market system by 2 o'clock, effectively taking down our financial system.

Consider also that according to CreditSight's "severe" test scenario, Citigroup(NYSE:C) and Bank of America(NYSE:BAC) combined could face another $200 billion in mortgage-related losses over the next two years. NYU Professor Nouriel Roubini estimates U.S. banking losses could peak at $3.6 trillion, which "means the U.S. banking system is effectively insolvent."

To see what happens when a banking system collapses, look no further than Iceland. Iceland's no banana republic -- in 2007, the United Nations called it the most developed country in the world. But in October, the country's banking system collapsed.

As a result, Iceland's currency has lost about half its value. Inflation is now 18.6% and rising. The central bank's interest rate is 18%. Unemployment has quadrupled. The stock market is down 90% since the end of September. It's ugly. And all this has happened before most of the aftershocks from second-order effects, like the results of skyrocketing interest rates.

The terrible thingThat said, there is one terrible thing about this bailout, which was barely addressed in the feedback on the original article. It's not the executive bonuses, corporate jets, spa getaways, or even moral hazard. Though it would be very bad if the banks started taking the bailouts for granted, I believe executive pay limits and the risk of humiliation should help curb most excesses.

Rather, the worst thing about the bailout is that this sort of government intervention distorts the market. If banks can earn interest on money deposited at the Fed, will banks be motivated to lend money to other banks? When the government provides short-term loans to businesses, it hurts private lenders who are forced to compete with the government.

In fact, ACE(NYSE:ACE), Loews(NYSE:L), and Chubb(NYSE:CB) have already suggested that AIG(NYSE:AIG) is using its federal bailout money to undercut competitors in commercial markets to maintain its market share. They have a point. While preventing AIG's bankruptcy to avoid cascading problems was reasonable, AIG should have been put into run-off, stopping the insurer from writing new business and eventually winding it down. At minimum, that should be the price of failure.

The Foolish bottom lineThe distortion of the market is the worst thing about the bailout. Nevertheless, the bailout still looks successful so far. The TED spread is under 1, implying that confidence is returning to the banking system. More importantly, the financial system is still standing. We may have seen the worst of the banking crisis, and if that's true, in two years, today's stock prices could look extremely cheap.

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Fool contributorRichard Gibbonsfigures that if he shills enough for Obama, he can pick up some of that stimulus package. The Fool'sdisclosure policyknows more about economics than Richard.